MACROECONOMIC DEVELOPMENTS REPORT JUNE

Transcription

1 MACROECONOMIC DEVELOPMENTS REPORT 2017 JUNE

2 MACROECONOMIC DEVELOPMENTS REPORT, No 25 Latvijas Banka, 2017 The source is to be indicated when reproduced. Latvijas Banka K. Valdemāra iela 2A, Riga, LV-1050, Latvia Tel.: Fax:

3 CONTENTS Contents Abbreviations 3 Introduction 4 1. External Demand 5 2. Financial Conditions ECB policy 7 Box 1. Shadow rate Other central bank decisions and financial markets Securities market Interest rates Credits and deposits 15 Box 2. Euro area bank lending survey results for Latvia Cross-border financial flows in the balance of payments 193. Sector Development Manufacturing Agriculture Construction Real estate market Trade Transport Gross domestic product GDP Analysis from the Demand Side Private consumption Investment Exports Imports Government consumption Labour Market Costs and Prices Conclusions and Forecasts Analysis of Scenarios 42 Statistics 47 Additional Information 99 2

4 ABBREVIATIONS Abbreviations APP asset purchase programme CIS Commonwealth of Independent States CSB Central Statistical Bureau of Latvia EC European Commission ECB European Central Bank EONIA euro overnight index average ESA 2010 European System of Accounts 2010 EU European Union EU28 28 countries of the EU EURIBOR Euro Interbank Offered Rate Eurostat statistical office of the European Union FAO Food and Agriculture Organization of the United Nations FRS US Federal Reserve System GDP gross domestic product GFCF gross fixed capital formation HICP Harmonised Index of Consumer Prices JSC joint stock company Ltd. limited liability company MFI monetary financial institution OPEC Organization of Petroleum Exporting Countries PIT personal income tax PJSC public joint stock company PMI Purchasing Managers' Index PUC Public Utilities Commission SJSC state joint stock company SRS State Revenue Service TLTRO targeted longer-term refinancing operations UK United Kingdom UN United Nations US United States of America VAT value added tax WTO World Trade Organization 3

5 INTRODUCTION Introduction In the course of the last six months, Latvijas Banka's assessment of economic development in Latvia has become more optimistic due to external demand becoming stronger and investment activity recovering gradually. At the end of 2016 and in early 2017, economic growth in Latvia accelerated, and the leading indicators of both global environment and major trade partners corroborate sustainability of improvements in the external economic environment also in the future. Meanwhile, financing conditions are favourable for lending, and the labour market shows signs of further improvement. More positive effects from the EU funding cycle for the economy are expected in the course of the year, with the domestic demand gaining momentum and GDP growing, in construction and related sectors in particular. Hikes in energy and food prices observed in world markets at the end of 2016 and in early 2017 triggered higher inflation rates. At the current juncture, the influence of external factors has become stable, while domestically strengthening economic activity and wage increases gradually provide a more positive domestic demand effect on inflation. Amidst wages growing faster than productivity and with the share of remuneration in value added approaching the EU average, the gains in Latvian export market shares point to resilience in competitiveness. Investment recovery is a basis for productivity growth, and already in the first quarter of 2017, the private sector investment project launching activity became brisker, public investment recovery was gaining momentum, and foreign direct investment inflows remained robust. Nevertheless, the course of domestic structural reform process and the development and stability of a competitiveness-enhancing tax system have not lost their significance for strengthening the long-term potential of the economy. 4

6 1. EXTERNAL DEMAND 1. External Demand 1 Previous assessment Developments since the previous report New assessment 1 External demand Moderate growth, albeit somewhat slower than previously expected due to weaker demand from Lithuania, Sweden and Poland Increase/strengthening of global commodity (oil including) prices in the first quarter; recovery of world trade; acceleration of euro area economic growth and improving confidence; upward revision of external demand forecast for Latvia. Moderate yet slightly faster-than-expected growth related to improved outlook across the euro area and for Latvia's major trade partners. The global economic environment is posting an overall improvement. Global financial conditions remain favourable, and economic growth is gaining momentum in an everincreasing number of world countries. In the US, expectations of growth-enhancing fiscal policy have softened; following the FRS's raising of the federal funds target rate in March, market participants are anticipating tighter monetary conditions to be introduced in a more gradual way. However, the conditions for US economic development remain favourable, including almost full employment in the labour market and wage growth. Meanwhile, other major central banks proceeded with accommodative monetary policy. The recovery of global trade flows is underway and is driven by growing global demand, including for investment, and rising commodity prices. Business confidence surveys (global PMI of new export orders) suggest that global trade will be growing likewise resiliently also in the future. Oil and other commodity price rises at the turn of the year triggered the recovery of demand in commodity-exporting developing countries. Via trade and confidence channels, this acceleration in their recovery is positively affected also by economic advance and improved confidence of market participants across developed countries as well as by more dynamic progress in and better outlook for the economy of China. For most countries, the oil price rise has been the decisive underpinning factor of a higher inflation rate, yet substantial pressures from oil prices are not to be expected, as oil and food prices have stabilised and the effect of demand on inflation continues to be weak. Despite inflation elevation in the euro area because of higher energy prices, core inflation remains very low due to delayed wage increases and a weak pressure from domestic prices. In the euro area, economic recovery is gaining momentum, basically driven by stronger domestic demand. Improvements in external environment have simultaneously translated into export expansion. Private consumption is facilitated by retained employment growth and improving consumer confidence. However, the labour market improvements have not been sufficient to speed up the wage growth as an effect of economic recovery; in addition, the augmenting of household real incomes was held back by hiking energy prices. Monetary policy continues to support the rebirth of investment and is expected, coupled with improved company profitability, to further spur it. The outlook for euro area GDP growth for 2017 has been revised slightly upwards by international institutions. The 2017 GDP growth outlook for Latvia's major trade partners has improved as well. It is determined by better-than-previously-projected economic performance and the dynamics of several leading indicators from future changes predicting surveys (e.g. EC compiled economic sentiment indicator and PMI). As stronger growth has given impetus to global 1 Colours in tables are used to show differences in the assessment of impact on Latvia's GDP and inflation vis-à-vis the previous forecast. Worsened Unchanged Improved 5

7 1. EXTERNAL DEMAND foreign trade, the forecast of external demand in 2017 for Latvia has undergone a quite substantial upward revision. Similar to Latvia, latest macroeconomic indicators recorded by Lithuania and Estonia are better than projected. The expansion of external trade accompanied with increasing public expenditure are the drivers of growth in both Lithuania and Estonia. Additionally, the financing from EU structural funds became available again in Nevertheless, the perspective for Latvian exports related to stronger external economic activity may be partly limited by the effect of demand structure, for, mostly resulting from a more buoyant investment activity, the demand is likely to grow for imported capital goods. Stabilisation of oil prices has brought about a better economic perspective for Russia. Its economy is expected to come out of the two-year long recession in The declining inflation and stable exchange rate both support the revival of private consumption growth, which is expected to be followed by a somewhat stronger investment activity. A more dynamic economic development, however, is likely to be restricted by still heightened uncertainty and weakness of structural growth factors. Direct dependence of Latvia's economy on Russia has diminished, while the latter's indirect impact via other economies of the region remains rather strong. The economic perspective has improved also for Germany. In 2017, its economic development is likely to be spurred by private consumption because further labour market improvements. The investment activity is likewise expected to be high, partly due to the immigration policy providing for public financing for social housing. Brisker investment and building activities are good news for Latvian exporters, primarily for manufacturers of building materials (e.g. wood and metal structures) and other products. The forecasts for growth in Sweden continue to be good. It will still be supported by the resilient private consumption as well as previously buoyantly strengthening investment and thereby also construction activity. The Latvian building companies and their associates manage to take advantage of the active residential stock construction in Sweden. The UK still experiences heightened uncertainty, resulting from the Brexit process and amplified by the outcome of the latest general election. This uncertainty is also mirrored by economic indicators, which show falling growth rates. Under the impact of depreciating British pound sterling import prices elevated, thereby also causing consumer price inflation to increase at the rate which exceeded the rate of wage growth. As a result, a fall in private consumption has occurred for the first time since PMI of the UK construction sector, which is significant for Latvia, suggests that the relatively sluggish first quarter growth will be followed by revived activity, and it gives rise to hopes that Latvia's exports of wood to the UK will manage to recover, at least in part, after the year-on-year fall experienced in the first four months of

8 2. FINANCIAL CONDITIONS 2. Financial Conditions 2.1 ECB policy Previous assessment ECB decisions Market expectations are in line with the decision by the Governing Council of the ECB to maintain the key ECB interest rates at the current level and to continue with the implementation of the expanded APP at least until the end of March Developments since the previous report Economic growth fundamentals and monetary aggregates continue to improve; at its June meeting, the Governing Council of the ECB expresses the view that the risks to the euro area growth outlook are balanced; at its June meeting, the Governing Council of the ECB decides to drop the reference to further key ECB interest rate cuts from its forward guidance. New assessment Market expectations are in line with the decision by the Governing Council of the ECB to maintain the key ECB interest rates at the current level and to continue with the implementation of the expanded APP at least until the end of 2017; raising of the interest rates is expected in the second or third quarter of Market participants expect that the forward guidance of the Governing Council of the ECB will be changed in September 2017 with respect to tapering the expanded APP. ECB continued to provide highly accommodative monetary policy conditions. In line with the previous decisions, purchases within the framework of the expanded APP continued in April at a monthly pace of 60 billion euro. At the same time, the practice of reinvesting the principals from maturing securities purchased under the expanded APP was continued. The final TLTRO II tender was conducted in March, with the allotment totalling billion euro. Some banks exercised the early repayment option for the amounts borrowed at TLTRO I tenders. Currently, the total amount outstanding within the framework of both TLTRO I and TLTRO II is billion euro. At its January, March, April and June meetings, the Governing Council of the ECB decided to keep the key ECB interest rates and the non-standard monetary policy measures unchanged. At its April meeting, the Governing Council of the ECB admitted that "the cyclical recovery of the euro area economy is becoming increasingly solid and that downside risks have further diminished". At the June meeting, the assessment of risk was raised even further and at the moment the Governing Council of the ECB considers the risks surrounding the euro area growth outlook to be broadly balanced. At its June meeting, the Governing Council also decided to introduce a change to its forward guidance and drop the reference to further key ECB interest rate cuts from it. Currently, the Governing Council of the ECB expects the key ECB interest rates "to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases". There was no change in the forward guidance as concerns the expanded APP: it is intended that the monthly pace will remain the same until the end of 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim. At the press conference of January 2017, Mario Draghi, President of the ECB, provided a more detailed explanation as to what is considered to be an appropriate level of inflation by naming four features characterising the compliance of the euro area inflation with the ECB's inflation target. First of all, it is inflation in the medium-term; second, it has to be a durable convergence (it cannot be transient); third, it has to be self-sustained, i.e. it has to stay on target even in the absence of the ECB's extraordinary monetary policy support; fourth, inflation has to be defined for the euro area as a whole. In the most recent months, with the inflation rising and other economic growth fundamentals improving, market participants started to expect tapering of the expanded APP purchases. 7

9 2. FINANCIAL CONDITIONS The latest surveys show that most market participants anticipate that the ECB will start progressively reducing the monthly purchases of securities under the expanded APP as of the first quarter of 2018 and that it will take six months to fully wind down the expanded APP purchases. Survey results as well as the probability implied by the euro overnight index swaps suggest that the ECB could raise the deposit facility rate as early as in the second half of The implied forward yield curve steepened slightly in May as compared to December 2016, suggesting that the market participants expect somewhat more notable raising of the target rate. Box 1. Shadow rate The current economic situation can be characterised as an era of low interest rates. After several years of monetary accommodation, the ECB has hit the zero lower bound mark. The main refinancing rates have been cut to levels close to zero and even lower. Traditionally, when explaining the monetary policies pursued by central banks and estimating the degree to which central banks need to reduce or increase the nominal interest rates to adjust to changes in inflation and other economic conditions in order to foster price stability and full employment, Taylor's rule 1 is used. Yet in the circumstances of zero interest rates the main refinancing rate of the central bank is not an adequate parameter to characterise the monetary policy stance because unconventional monetary policy measures, like the expanded APP and long-term lending operations, are used to enhance accommodation. To characterise all the central bank's accommodative monetary policy measures, a new indicator, the so-called shadow rate, can be employed. The shadow rate is derived from the term-structure of risk-free interest rates by applying mathematical models and can be used to estimate the future effect of the monetary policy on various macroeconomic variables. The shadow rate is not directly observable but acts as a measure of what the main refinancing rate of the central bank would be in the absence of a zero lower bound for interest rates and if the central bank used only the main refinancing operations instead of the non-standard monetary policy instruments. 1 Taylor, J. B. Discretion versus Policy Rules in Practice. Carnegie Rochester Conference Series on Public Policy 39, December 1993, pp

10 2. FINANCIAL CONDITIONS The shadow rate estimated by Latvijas Banka (currently, 2.3%; see Chart 1.1) is derived based on average euro overnight index swap (OIS) rates over the period of three months to ten years. As overnight loans granted to major banks are mainly considered risk-free, OIS can be used to estimate the long-term risk-free interest rates. In normal circumstances, the shadow rate tracked the money market rates closely. With interest rates approaching zero and the ECB employing the unconventional monetary policy instruments, the shadow rate moved away from the money market rates. The first dive of the shadow rate below EONIA happened in mid-2011 when the ECB announced the expansion of the Securities Markets Programme and the next one in November 2011 following the ECB's announcement of the start of longer-term refinancing operations. The shadow rate entered a negative territory for the first time in April 2012 after Mario Draghi, the President of the ECB, announced: "within our mandate, the ECB is ready to do whatever it takes to preserve the euro", thus affecting the market expectations. Comparing the theoretical rate implied by Taylor's rule and the shadow rate of the euro area, one can conclude that, since the end of 2013, the shadow rate was able to follow the Taylor rule-implied rate into the negative territory regardless of the non-standard monetary policy stimulus provided by the Eurosystem. Moreover, it remained close to the upper bound of the Taylor rate's range. Following the gradual recovery trend observed in the euro area economy, the range of the Taylor ruleimplied rate started to move upwards in 2015, whereas the shadow rate remained low, pointing to the presence of significant monetary stimulus provided by the ECB. 2.2 Other central bank decisions and financial markets Previous assessment Developments since the previous report New assessment FRS decisions Market participants expect that the target rate will be raised at December 2016 and March 2017 meetings. At the same time, market participants expect more significant increases of the target rate in the upcoming three-year period. At its December meeting, the FRS raises the target range for the federal funds rate from 0.25% 0.50% to 0.50% 0.75% and then to 0.75% 1.00% at its March meeting; FRS anticipates that a change in reinvestment policy regarding maturing bonds would be appropriate in the near future; the new US administration is slow on the promised reforms, market participants lose faith in the implementation of growth-supporting future policies; US labour market indicators continue to improve, economic activity strengthens, while the inflation growth is lower than expected; longer-term bond yields are increasing. Market participants expect that the target rate for federal funds will be raised at June 2017 meeting. At the same time, market participants expect flattening of the path of the target rate for federal funds as of Bank of England's decisions Market participants anticipate that the target rate will remain at a lower level in the upcoming three-year period. The process of the United Kingdom's withdrawal from the EU has commenced; UK Prime Minister Theresa May announces a snap general election. Market participants anticipate that the Bank of England's Bank Rate will remain unchanged at the level of 0.25% at least until the end of

11 2. FINANCIAL CONDITIONS Bank of Japan's decisions Market participants anticipate that the target rate will remain low in the upcoming three-year period. EUR/USD exchange rate Market participants anticipate that the euro will depreciate against the USD (to 1.04 USD per euro) in a year. Bank of Japan raises the GDP forecast and adjusts downwards the inflation forecast; inflation and consumer expectations concerning the level of future prices decrease. Political risks in the euro area subside; market participants lose faith in fast implementation of growth-supporting policies in the USA. Market participants anticipate that the target rate will remain low in the upcoming threeyear period. Market participants anticipate that the euro exchange rate against the USD will be 1.10 USD per euro in a year. Financial market sentiment was positive at the beginning of Stock price volatility was low and overall the prices somewhat increased. Central bank policies continued to influence the financial market developments. Investors kept a close watch on the first instructions given by the new US President Donald Trump to see whether they fulfil the promises made in the run up to the elections. In the euro area financial markets, investors continued to follow the unfolding of the Brexit scenario and the developments related to the upcoming Presidential elections in France. With the Presidential elections in France approaching, volatility increased in April and the prices of safe assets went up. The good polling results of Marine Le Pen caused jitters on the financial markets because of her anti-european political beliefs and the resultant prospects of France potentially leaving the EU. Once the centrist and pro-european candidate Emmanuel Macron took over the lead at polls, particularly after the first round, and subsequently gained the voters' support at the second round, the political risks in the euro area subsided and the financial market sentiment improved. In May, the euro exchange rate vis-à-vis the US dollar reached the highest level of the last six months, the prices of riskier assets increased, whereas those of the most safe bonds slightly decreased. During the first four months of 2017, the euro exchange rate vis-à-vis the US dollar followed a moderate upward trend which steepened in May when the political uncertainly in the euro area declined and that in the USA heightened. In May 2017, the euro appreciated by 6.7% in comparison with December 2016, with its exchange rate vis-à-vis the US dollar going from 1.05 USD per euro to 1.12 USD per euro. The market participants' expectations regarding the euro exchange rate in the coming 12-months period have heightened since the November assessment (to 1.10 USD per euro). 10

12 2. FINANCIAL CONDITIONS With the investor optimism concerning the ability of the newly-elected US President to fulfil his pre-election promises and implement business growth supporting policies fading, the positive response of the financial market observed at the turn of 2016 turned flat. Failure to go ahead with the promised health care reform made market participants question the new-elected President's ability to keep his promises, thereby having a negative effect on the market sentiment. As already expected by the market participants, the Federal Reserve Board raised the target rate for federal funds by 0.25 percentage point (to the target range of 0.75% 1.00%) at its March meeting. At the same time, contrary to the market expectations, no announcement of an intention to potentially raise the rate more substantially in the future was made. The slope of the implied term structure curve of the federal funds rate flattened slightly as of 2018 after several FRS participants revealed that reinvestment of maturing bonds could be discontinued in the near future. This is a restrictive monetary policy step, implying that the future path of the base rate of the central bank could be flatter in the future. Despite the growing inflation, Bank of England continued with an accommodative monetary policy as it was warranted by the weakening of the domestic demand and its forecasts. Bank of England maintained its Bank Rate at the level of 0.25%, with the size of the asset purchases also remaining unchanged at 435 billion British pound sterling. Market expectations concerning the future actions of the Bank of England have also remained unchanged and no raising of the Bank Rate is projected in the course of Moreover, market participants anticipate the Bank of England's target interest rate to remain low in the coming three years. Bank of Japan continued with a particularly accommodative monetary policy and abstained from any new decisions in the reporting period. It kept unchanged the short-term policy interest rate at 0.1%, the target level of 10-year government bond yields at 0% and the annual pace of increase of the monetary base at 80 trillion Japanese yen. At the same time, Bank of Japan upgraded the outlook for economic growth from "moderate recovery" to "moderate expansion". Quite naturally, the implied term structure curve of Bank of Japan's policy rate remained constant since December 2016, suggesting that the market expects the central bank to continue accomodative monetary policy. 2.3 Securities market During the first five months of 2017, 2 10 year yields of euro area government bonds increased. This was supported by the relatively robust economic growth observed in the first quarter of the year offsetting the negative effect of the political uncertainties (Brexit, Presidential elections in France). Moreover, the economic growth of the euro area outpaced that of the USA. Starting from mid-april when the victory of Emmanuel Macron at the Presidential elections in France became more certain, the political risks in the euro abated and the spread between the 10-year French, Spanish and Italian government bond yields and the same maturity German government bonds narrowed. Nevertheless, a rather considerable 11

13 2. FINANCIAL CONDITIONS degree of uncertainty remains with regard to the upcoming Parliamentary elections in Italy scheduled for May Moreover, the current polls are dominated by the populist Five Star Movement (Movimento Cinque Stelle). Some euro area countries experienced a decline in the government bond yields. For example, the 10-year Greek and Portuguese government bond yields contracted as the decrease in the fiscal risks in those countries was more substantial than the upward pressure on the yields caused by the economic growth. The Eurosystem purchased public sector securities within the framework of the expanded APP based on the capital key, at the same time demonstrating certain flexibility of the programme. For example, April data revealed that the Eurosystem had slightly stepped up the purchases of the French government securities, most likely with a view to easing the tension ahead of the French Presidential elections. Consequently, in order to preserve the capital key proportions and implement a market-neutral expanded APP, the purchases of the French government securities made in some other months will have to be reduced accordingly. During the period of rising interest rates, auctions of Latvian government securities were only organised on three occasions, offering 3-year and 5-year bonds. Meanwhile, Latvia launched euro bonds with a 10-year and 30-year maturities on the international financial markets on 9 February (both issues together totalling 650 million euro) in order to cover most of the borrowing scheduled for 2017 as well as to benefit from the low interest rate environment. 30-year euro bonds had the historically longest maturity, their yield was 2.33%, with the spread of 98 basis points above the mid-swap rate. At the same time, an additional issue of 10-year bonds, maturing in October 2026, was launched, with the yield set at 1.062%. The yield of the 10-year Latvian government bonds was the lowest in comparison with other similar-rating countries. Two different-maturity additional euro bond issues were launched by Latvia on the international financial markets on 1 June for the total amount of 350 million euro, covering the rest of the borrowing scheduled for The yield of the 10-year bonds was 0.95% (with the spread of 23 basis points above the mid-swap rate), whereas that of the 20 year bonds was 1.70% (with the spread of 35 basis points above the mid-swap rate). 12

14 2. FINANCIAL CONDITIONS 2.4 Interest rates Previous assessment Developments since the previous report New assessment Interest rate on loans to non-financial corporations and households A slight decrease due to the decline in the euro money market rates. Euro money market rates continued to decrease; the pressure from competition motivated some credit institutions to reduce the margins; creditworthiness of businesses improved. A slight decrease due to the shrinking of the risk premium priced into the lending rates and persistently favourable euro money market conditions. Interest rate on household loans A slight decrease due to the decline in the euro money market rates. Euro money market rates continued to decrease; t he pressure from competition motivated some credit institutions to reduce the margins; creditworthiness of households improved. A slight decrease in the interest rates of consumer credit and other credit granted to households due to the shrinking of the priced-in risk premium. Interest rates on loans for house purchase unchanged. In the fourth quarter of 2016 as well as from January to April 2017, the lending margins on new euro loans narrowed slightly in all major sectors of Latvia's credit market. A lower risk premium was priced into the lending rates due to the tightening of competition among Latvia's credit institutions and an improvement in the borrowers' creditworthiness supported by the general economic development and that of particular sectors. A minor reduction of the lending and deposit rates can be expected in the coming quarters as well. The financing costs of Latvia's credit institutions have decreased further in comparison with October Most deposits by households and non-financial corporations are demand deposits and savings deposits with interest rates close to zero or negative. The interest rate on demand deposits in euro continued to approach zero in the reporting period. Nevertheless, households and non-financial corporations do not seem willing to increase their investments in longer-term fixed-term deposits on Latvia's deposits market. Although some households and non-financial corporations continue to make longer-term fixed-term deposits as well as place deposits with smaller credit institutions offering higher interest rates, the share of fixed-term deposits in euro in all deposits received from households and non-financial corporations tends to shrink. Despite the rising interest rates, the growth of the proportion of deposits made in the US dollar and other currencies subsided in the reporting period. Lending rates continued to decrease slowly in Latvia's major lending segments, as a significant part of the loans has a floating interest rate which is directly affected by the further decline of the euro money market rates. Moreover, the margins on new euro loans granted by Latvia's credit institutions also tend to decrease gradually. Interest rates on outstanding household loans for house purchase and loans to non-financial corporations remained slightly above 2%, whereas the rates applied to consumer credit and other credit to households declined by 0.1 percentage point, reaching 11.7%. As regards new euro loans, lower interest rates were applied on loans to non-financial corporations, household loans for house purchase as well as consumer credit and other credit to households in the reporting period. In all the above segments, the interest rates decreased on account of a gradual narrowing of the margins supported by the tight competition among the credit institutions. 13

15 2. FINANCIAL CONDITIONS With the overall economic growth and that of particular sectors strengthening, the financial soundness of non-financial corporations improved and they could qualify for cheaper loans. The decrease in the interest rates on new small and medium-sized euro loans to non-financial corporations observed since October 2016 was more substantial than that in the case of large loans. Some significant Latvia's credit institutions narrowed their margins on loans to small and medium-sized enterprises in the reporting period, as they had a positive outlook on Latvia's economic growth prospects and those of individual sectors and were also struggling to retain their positions in Latvia's credit market. Although the interest rates applied to new euro loans to non-financial corporations in Latvia have been reduced, they remain higher than in most of the other euro area countries. 14

16 2. FINANCIAL CONDITIONS Interest rates on household loans for house purchase as well as those on consumer credit and other credit decreased as, motivated by competition, credit institutions cut their margins, but also because the risk associated with the granted loans was also lower. Non-interest charges on household loans for house purchase and consumer credit remained broadly unchanged in the reporting period. 2.5 Credits and deposits Previous assessment Developments since the previous report New assessment Lending A steady increase in the total loan portfolio and that of non-financial corporations in 2017 (active absorption of EU funds serving as the major factor). Recovery of the annual growth rate of lending to households already in the second half of 2017, with government continuing the support programme for house purchase for new families. New loans to both non-financial corporations and households have expanded; the support programme for new house purchase is ongoing; activity and prices in the real estate market have augmented; more active absorption of EU funds has started; JSC "Attīstības finanšu institūcija Altum" together with credit institutions offers credit guarantees for small and medium-sized enterprises and a new support programme aimed at granting loans for renovation of residential buildings. A steady increase in the total loan portfolio and that of non-financial corporations will continue in 2017 and 2018 (active absorption of EU funds, growing capital of non-financial corporations and their readiness for investment serving as major factors). Stabilisation of the annual rate of change of lending to households in the second half of 2017, with government continuing the support programme for house purchase for new families and with the demand for consumer credits rising. At the end of 2016 and in early 2017, credit institutions continued a gradual acceleration of lending to the economy, i.e. both the total domestic loan portfolio and loans to non-financial institutions recorded an increase during five of the last seven months, while the shrinking of the household loan portfolio decelerated. The annual growth rate of total domestic loans, including loans to non-financial corporations and households, was in positive territory (in April, 2.5% and 1.7% respectively). It was only the annual rate of change in loans to households that approached zero every month, although it remained negative ( 1.1% in April). Since the uptrend in loans to the non-bank financial sector decelerated, lending to nonfinancial corporations played the central role in lending growth. The investment recovery has started to contribute to the demand for loans despite the hindering effect of the slow increase in access to EU structural funds which decelerates progress of construction projects. Fight against the shadow economy, the Eurosystem's accommodative monetary policy in a persistently low interest rate environment and the stable credit standards, which 15

17 2. FINANCIAL CONDITIONS are slightly eased in certain cases, have a positive effect on lending. An entrepreneurship programme of the JSC "Attīstības finanšu institūcija Altum" regarding credit guarantees for small and medium-sized enterprises (150 million euro have been foreseen for this purpose in 2017) and its household sector support programme for house purchase for new families facilitate lending. A new support programme aimed at granting loans for renovation of residential buildings has been launched in Lending to households is also fostered by the increasing demand for consumer credit supported by favourable consumer confidence dynamics in the first four months of The growing activity in the real estate market generates a positive environment in long-term lending. An increase in new loans mirrors these trends. During the seven months from October 2016 to April 2017, new loans to non-financial corporations exceeded the indicators of the respective period of 2015 and 2016 by 13.5%, loans to households for house purchase by 18.1% and consumer credit by 18.2%. The annual rate of change in new domestic loans reached 15.6% in the above period. It was primarily the expansion of domestic deposits that provided funding for the moderate growth in loans. This growth was close to the economic growth rate, and in April it exceeded the level of the respective period of the previous year by 4.0%. The annual growth rate of deposits received from non-financial corporations and households was steeper (4.7% and 8.8% respectively), continuing to point to a slower increase in consumption in favour of a 16

18 2. FINANCIAL CONDITIONS rise in deposits. The change in the policy concerning the allocation of financial institutions' savings hindered the expansion of total deposits until March, resulting in the reduction of deposits in domestic credit institutions. For quite some time now, monetary data suggest that cooperation between the real economy sector and credit institutions has been successful, i.e. with economic indicators moderately improving, non-financial corporations (and also households) steadily increase their deposits with credit institutions which, in turn, stimulate lending to businesses, thus providing a common contribution to economic development. Dynamics of both the loan portfolio and new loans demonstrate that the trend of moderate growth in lending to businesses will continue, and the second half of the year might also see a minor increase in the household lending portfolio. Nevertheless, the positive changes in the household loan portfolio witnessed by the household sector will be slowed down by the high level of repayment of long-term loans granted during the pre-crisis period. The euro area bank lending survey of March 2017 suggests that the situation in the credit market was stable in the first quarter of 2017, and it is projected that credit standards will remain unchanged in the second quarter. Meanwhile, the demand for loans by individual non-financial corporation segments has increased, and it is expected to pick up in the second quarter. Moreover, several credit institutions project a rise in the demand for household loans in the second quarter. With lending to non-financial corporations recovering somewhat stronger than expected, there are grounds for improving forecast in lending to non-financial corporations, while the forecast in lending to households remains broadly unchanged, i.e. the annual rate of change will stabilise in the second half of Box 2. Euro area bank lending survey results for Latvia Effect of ECB non-standard monetary policy instruments The results of the euro area bank lending survey suggest that the negative ECB deposit facility rate has the greatest impact on Latvian banks. In the second half of 2016, the negative ECB deposit facility rate contributed to a decrease in the interest rate on loans to non-financial corporations and households for house purchase in two of the four surveyed Latvian banks and in one bank on consumer credit and other lending to households. One bank reported that the downward trend of interest rates associated with the negative ECB deposit facility rate triggered an increase in the segment of new loans to households for house purchase. Meanwhile, a half of the surveyed Latvian banks mentioned a negative aspect, i.e. their net income edged down in the second half of 2016 due to negative deposit facility rates. In response to questions concerning the participation in TLTROs, Latvian banks pointed out that the main reason why they were tempted to participate in the TLTROs is the attractive terms enabling them to improve their profitability. By contrast, the main reasons keeping Latvian banks from participation in the TLTROs are the restrictions on collateral and the lack of limitations on funding as well as sufficient liquidity. In the fourth quarter of 2016, Latvian banks used the funds obtained through the TLTROs for substituting the resources 17

19 2. FINANCIAL CONDITIONS drawn from other Eurosystem's liquidity providing operations (mainly funding received within TLTRO I) and interbank loans. One Latvian bank has slightly improved its liquidity position through participation in the TLTROs. Credit standards, terms and conditions and demand Currently all surveyed Latvian banks have tighter credit standards than those witnessed, on average, since the first quarter of 2003, but they are less tight than those prevailing, on average, since the second quarter of A trend of slow easing of credit standards is present in the segment of lending to households. In the fourth quarter of 2016 and the first quarter of 2017, i.e. for two consecutive quarters, one Latvian bank slightly eased its credit standards for loans to households for house purchase as well as for consumer credit and other lending to households. Competition among banks played the key role in the slight easing of credit standards in both sectors of lending to households. In addition, credit standards for consumer credit and other lending to households were eased also because of the growing non-bank competition and rising credit institutions' risk tolerance limits. It is expected that the standards in this lending sector might be slightly eased also in the second quarter. Latvian banks did not change credit standards for loans to non-financial corporations neither in the fourth quarter of 2016 nor in the first quarter of However, one bank intends to slightly ease credit standards for loans to small and medium-sized enterprises in the second quarter of Similar factors contributed to the use of slightly eased terms and conditions for loans to households. In the first quarter of 2017, one Latvian bank somewhat reduced the margin on loans to households for house purchase and slightly eased general terms and conditions for consumer credit and other lending to households. Even though the terms and conditions for loans to non-financial corporations were mainly eased in the first half of 2016, they were somewhat tightened between the fourth quarter of 2016 and the first quarter of In the fourth quarter of 2016, one Latvian bank slightly raised its non-interest rate charges for loans to small and medium-sized enterprises, and one bank increased the spread over the money market reference interest rate on risky loans to large enterprises in the first quarter of 18

20 2. FINANCIAL CONDITIONS A Latvian bank tightened terms and conditions for loans to non-financial corporations in relation to prevention of money laundering and financing of terrorism. In the fourth quarter of 2016 and first quarter of 2017, the demand for loans in Latvia's credit market increased further both in the sector of non-financial corporations and that of lending to households. Banks observed that it was the demand for loans by small and medium-sized enterprises that had expanded more during the reporting period. This was facilitated by the necessity of enterprises to invest in fixed assets and use short-term loans to supplement their inventories and current assets, refinance and restructure their debt as well as agree on new conditions. The household sector saw a rise in the demand for consumer credit and other loans for two consecutive quarters since households needed funding to purchase durable consumer goods (cars, furniture, etc.). Latvian banks expect that the demand by all lending sectors for loans to enterprises, loans to households for house purchase as well as for consumer credit and other lending to households will continue to grow. Overall, the results of the euro area bank lending survey suggest that the credit market situation is favourable for further recovery of lending. The non-standard monetary policy instruments employed by the ECB, competition among banks and the raising of the risk tolerance limits contribute to the decline in lending rates as well as to easing of terms and conditions with regard to other loans. The necessity to make long-term investment of different kinds and low interest rates facilitate demand in the environment of increased economic activity. 2.6 Cross-border financial flows in the balance of payments The cross-border financial flows in 2016 overall were affected by the decisions made by both the private and public sectors. Foreign assets posted a higher increase of 2.0 billion euro than foreign liabilities growing by 1.5 billion euro. The foreign assets reflected in the financial account expanded more than liabilities in the first quarter of 2017 (by million euro and million euro respectively). 19

21 2. FINANCIAL CONDITIONS In 2016, the largest cross-border financial flows in the private sector on the asset side accounted for decreases in the deposits of credit institutions with foreign banks and in portfolio investment abroad totalling 2.3 billion euro. This was driven by outflows of foreign customer deposits with Latvian credit institutions on the liabilities side observed already since the beginning of 2016 (3.2 billion euro in 2016; 32.9 million euro in the first quarter of 2017), which were offset by credit institutions by cutting their foreign assets. In the first quarter of 2017, portfolio investment abroad continued on a downward trend, but credit institutions' deposits with foreign banks increased. Changes in the deposits of some credit institutions reflect the regular interbank transactions which are affected by the bank group decisions on intra-group liquidity shifts. The flows determined by the public sector decisions were primarily related to the participation of Latvijas Banka in the expanded APP within the framework of the Eurosystem's monetary policy measures. Overall, Latvijas Banka invested 2.7 billion euro in foreign assets in The programme continued also in the first quarter of

22 3. SECTOR DEVELOPMENTS 3. Sector Developments Previous assessment Manufacturing Robust growth in 2016, weaker but still resilient growth in Construction Marked output contraction in 2016; recovery in 2017 slightly more moderate than projected. Transport Substantial freight volume contraction in transportation by rail and at ports in 2016 but lesser respective drop expected in 2017; as of road transport, the swift previous acceleration is unlikely to continue (the sectoral value added is likely to shrink overall). Real estate market Gradual recovery of housing prices and market activity in 2016, which is likely to become more pronounced in 2017 due to lending expansion. Trade Positive contribution from oneoff factors actual in 2016, likely to weaken in 2017; new factors mostly unlikely to push up demand, hence aggregated sector growth in 2017 expected smaller than projected. Developments since the previous report Robust growth towards the close of 2016, with slight deceleration in the first quarter of 2017; moderately optimistic sectoral and business assessment for 2017 in general. The downward trend discontinued at the end of 2016; the beginning of 2017 characterised by buoyant growth; the sector association predicts a large construction output concentration in Recently better freight volume developments at ports and by rail than expected. Serial type apartment price hikes to accelerate gradually; market activity continuously on a moderate rise, exceeding the notable increase in transaction activity of Volatile output dynamics at the end of 2016 and in early 2017; several intra-sector projects announced, with the impact from them felt in a longer term. New assessment Resilient growth in Accelerating construction activity expected to promote output growth in some subbranches of manufacturing. Strong recovery in 2017; fund profile likely to boost sector activity in Transport sector stabilisation: in 2017, improvements in rail transportation and at ports vis-à-vis the previous year are expected; growth in transportation by road, on the other hand, likely to be blocked by protectionist measures in the EU countries. In comparison with 2016, the sectoral value added unlikely to rise notably. Further rise in housing prices and market activity in The 2017 sector growth similar to 2016 trends, with somewhat faster pace of sector development possible in up-coming years. 3.1 Manufacturing The end of 2016 and the beginning of 2017 were very successful periods for manufacturing. In the fourth quarter of 2016, sector's value added picked up 10.1% (according to seasonally and calendar day adjusted data), while a 10.3% increment was recorded for the first 21